Friday, 6 June 2014

What we do know

After reading all about the latest ECB moves, I happened to
read this by Noah Smith (HT MT). It made me
unusually irritated, but it is not really Noah’s fault. He is right that there
is much that we do not know in macro, and also right that there are many
different views around. Alternative assessments of how effective the ECB’s policy
changes will be illustrate that. Noah puts all this down to lack of data, rather
than politics. When it comes to unconventional monetary policy this is also
right. However there are some things where the data is pretty clear, and where
any macroeconomist with an open mind should be able to come to a clear
conclusion. But somehow this does not happen.

When pouring over the detail of what are minor moves by the
ECB, there is a huge elephant in the room: fiscal policy. Too often this is
portrayed by those outside as a game with two sides: the PIIGS, where austerity
is a necessity because of difficulties in funding debt, and Germany, where
there is no domestic interest in offsetting periphery austerity with fiscal
expansion. However there is a third bloc of countries in the Eurozone, where
there has been no debt funding crisis, but where there exists a large amount of
spare capacity. This bloc is dominated by France (2014 output gap -3.4% as
estimated by the OECD), but also includes the Netherlands (output gap -4.4%),
Belgium (output gap -1.7%), Austria (output gap -3.2%) and Finland (output gap
-3.8%). The chart below shows what is happening to fiscal policy in those
countries.

Underlying Primary Balances: OECD Economic Outlook May 2014

All of these countries are tightening their fiscal policy this
year and next: in the case of France, Finland and the Netherlands quite
substantially. So the focus on Germany as a country (as opposed to its influence
on Eurozone institutions), where the OECD projects some very modest fiscal
expansion, is misleading. Damage is being done elsewhere, and for this
group of countries where negative output gaps are large fiscal policy is just perverse.

The theory and evidence behind this last statement should not
be controversial. The theoretical framework used by monetary institutions
almost everywhere says that fiscal contraction at the zero lower bound will do
serious damage to output and unemployment (and therefore reduce core
inflation). The evidence overwhelmingly confirms this proposition. While the
reasons for the Great Recession may still be controversial, the major factor
behind the second Eurozone recession is not: contractionary fiscal policy, in the core as well as the periphery. So this
is something we really do know. Yet too many macroeconomists seem reluctant to
acknowledge this. There are the anti-Keynesians
who want to deny the monetary policy consensus; there are others, who want to deny
the importance of the zero lower bound; and still more, who for some other
reason want to deny the importance of fiscal policy.

This allows policymakers to continue to press for fiscal consolidation in
the Eurozone, largely ignoring those economists who do challenge this policy because they just represent 'one view' within the discipline. Every reluctant and far too late bit of stimulus by
the ECB is undone by the actions of the Commission and the political consensus
behind austerity in Europe. As far as economists are concerned, although our
macroeconomics is much better than it was 50 years ago, in this case our
collective influence on policy has gone backwards.

42 comments:

" fiscal contraction at the zero lower bound will do serious damage to output and unemployment "

Serious damage when? Today, okay, understand. But that's strikes me as a pretty low bar. The idea of austerity, as I understand it, is to pay the pain now for benefits down the road. To use the dreaded metaphor of household economics, you can buy the TV now but then you have to pay back debt in five years, and so suffer less consumption in five years. So, what is the evidence that austerity for say three years produces worse results over a ten-year period than stimulus for three years?

It's the notion of the output gap: how much more the economy could produce without generating significant inflation. Simplistic household economics metaphors don't really apply.

One that does is from agriculture. The winter off-season is a good time to do repairs around the farm, like mend fences, etc. You're not planting or harvesting.

Governments can borrow cheaply now. It's a good time to do infrastructure repairs and investment. Once the output gap is closed and inflation starts rising, government borrowing will become more expensive.

Thanks for your answer. It depends on a particular type of spending (infrastructure repair), but W-L's point is about generic spending. So I'm afraid I don't find it convincing.

Look, I get it's rational if the government invests now in projects with a return on investment higher than the interest rate at which is borrowing money. But it is a good thing whether or not we're at the zero lower bound - no Keynesian economics needed. Because interest rates are low at the zero lower bound, there may be more projects which meet this criteria, but there again no need for Keynes.

Peter , your statement is so wrong on so many levels , that it is even impossible to debate from a practical point of view ; so as a starter, every time someone tells you something that sounds like common sense ( the housing economics analogy ) , I suggest you are safer to believe exactly the opposite . Here is why:Go to a field and look around you. It's common sense to say the world is flat , right ?

Being a longtime reader of Professor Wren-Lewis and other keynesian economists, perhaps I can help you understand.

One way to think of this is in terms of a loanable funds model (google it!). In normal times, fiscal contraction will lead to a shift down in the investment curve but this effect is partly mitigated because it also lowers the interest rate which makes it more attractive to invest, consume and lowers the exchange rate(more exports, less imports). Fiscal contraction will still make aggregate demand decrease but this causes the central bank to lower the interest rate further which once again increases investment consumption etc. In simple english, most of the fiscal contraction is offset by other forces during normal times.

As pointed out however, We are today still living at the zero lower bound. In the loanable funds model this shows up as a vertical line above the point where investment meets savings. This means that at the current interest rate just above 0% there is too little investment and too much in the way of savings. A fiscal contraction (shift downwards of the investment curve) in this situation will not lead to increased investment because the actual interest rate can't decrease and because the central bank can't lower the interest rate in response.

This is one way to explain why fiscal contraction today, under the zero lower bound, is far more harmful than fiscal contraction a few years in the future would be.

A far simpler way of showing this is by pointing at multipliers. In normal times, most researchers have concluded that they are somewhere between 0.3 and 0.6 meaning a cut in public expenditure of one billion euros makes the economy 300-600 million euros smaller. Using data from the last few years, the IMF has estimated the eurozone multiplier to be 1.7 (a one billion cut leads to an 1.7 billion loss for the economy).

Hugo André, thanks for your reply. As I understand you, for stimulus of x, at time=0 multiplier of 1.7, so GDP increases by 1.7 * x, at time=t multiplier of 0.6, so GDP is lower by 0.6, so total GDP over the period is higher. Fine. You need a few more assumptions, but fine. (If I have time, I may come back...) What is the limit on x? For instance, government expenditure in France is now 56% of GDP, so near the high. It would seem 10% GDP more government spending in France is simply not possible, and it would seem one would expect an increase in government spending in France to have a lower multiplier than otherwise. Is that so? As to the conclusion of the IMF about the eurozone multiplier, the eurozone had a sovereign debt crisis, so one would want to know the multiplier of the eurozone minus those countries which had a sovereign debt crisis (and with the impact of e.g. Spain's lower GDP on France taken into account, etc.) Is that anywhere?

As I wrote in the first post, the biggest reason for the large size of the multiplier is that the eurozone is in a liquidity trap which is a problem for all the countries in the zone. Even if there is a large variation in the size of the multiplier between these countries, there is good reason to believe that France comes somewhere in the middle as a country that has been on the verge of entering the storm. Ireland, Portugal, Spain, Italy and Greece have a combined GDP that is slightly larger than that of Germany (roughly 120% of german GDP) so if the multiplier is larger in the former countries (and by the same reasoning smaller in Germany,) France probably still has a multiplier of 1.7 or slightly below.

Let's think through the numbers you've thrown out. 10% (of) GDP more government spending in france would, with a multiplier of 1.7 lead to an increase of 17% in GDP growth! Mind you a multiplier of 1.7 might not be valid for such a massive increase in government spending. A fiscal expansion of just 2% of GDP would have a very substantial effect on growth (as well as on unemployment, deflation-avoidance etc). Keep in mind that the french government is currently undergoing austerity and that just ending this will have a large positive effect on growth without leading to a higher share of government expenditure as a share of GDP. Perhaps more importantly, the most effective government stimulus will be one that is focused on investment (building infrastructure) rather than an increase of transfers or pensions. This means that the increase only lasts for a year or a few years and does not lead to any permanent increase in the govt. spending/GDP ratio.

For so long as economics as a whole - and journals in particular - keep professionally rewarding people that play devil's advocate this fragmentation will continue.

New economists do not make their name by producing empirical studies that reaffirm existing mainstream theories. This is an in built dynamic that creates this nonsense. T

Having studied economics and now being a lawyer in my view the key problem in economics is that there is no Supreme Court so to speak. Lawyers argue over what the law is or is not but - at least to a large extent - once the Supreme Court decides the issue the matter is settled for better or worse. Academics can continue to argue that the decision was right or wrong but at the coal face practicing lawyers - if they are to be competent - must give advice based on the ruling of the SC.

In economics however there is no agreed method or forum for determining what the current position of the profession is in relation to an issue. The view of the central bank board is the closest that exists. In the long run this is why fiscal councils are clear - appointments to the council ought to be the equivalent as appointments to the SC - indeed one can see this happening already in relation to the federal reserve.

to continue the above - (sorry double post) - economics would be better off to stop trying to be ever closer to a hard science and instead start trying to be more of a profession wherein there is an accepted body of knowledge.

Well Anonymous @15:19, you're not much help. "Your statement is so wrong on so many levels." Which statement? The one on household economics? You did see I qualified it with "dreaded" right? So try not to get your knickers into such a twist. OTOH, the household economics metaphor does show one cannot infer, at least immediately, the assertion that (M) something is good in the middle-term from the assertion that (S) something is good in the short-term. So evidence should be provided for M. and my question at the end of my first comment is a request for evidence in the case of stimulus. To expropriate your own analogy, that the field is flat does not imply, one way or the other, whether the Earth is flat. So, even though I can see the field is flat (S), I still need evidence to believe the Earth is not flat (M). BTW, I am not asking to debate; debating with someone who writes as unclearly as you would be an unprofitable task to say the least.

According to the OECD, Austria nevertheless has a large negative output gap: resources are being wasted. GDP growth in 2012 and 2013 was low (around 0.5%), and inflation is also falling, so there seems scope for additional demand. Although a negative output gap normally goes with higher unemployment, it does not have to.

Could you give a link for the OECD output gap estimates? I do not find them in their Economic Outlook May 2014; what it does say there is that the US output gap in 2013 was 3.5 %, i.e. worse than Austria's, which has inflation to boot due to a raised excise tax.

"While the reasons for the Great Recession may still be controversial, the major factor behind the second Eurozone recession is not: contractionary fiscal policy, in the core as well as the periphery. So this is something we really do know."

It only because of the continuous issuance of preposterous statements like this by people who should know better, that the causes of the Great Recession are even controversial. Not only is this something we do not know, it is something that we know is not true.

The second Euro Area recession was clearly monetary in origin. The ECB raised the MRO rate from 1.0% to 1.25% in April 2011 and then to 1.5% in July. The six quarter second recession started the following quarter. The Euro Area was never near the zero lower bound in interest rates and the ECB chose to raise the policy rate in the face of projections that core inflation would remain below target and the output gap would remain high for at least the next two years.

The US makes a useful comparison. The Fed kept the fed funds rate near zero throughout 2010-2013 and elected to do a second round of QE in late 2010 to mid-2011 and to start a third round in late 2012. The ECB has yet to initiate even a single round of QE.

According to the April 2014 IMF Fiscal Monitor the US increased its cyclically adjusted primary balance (CAPB) by 4.7% of potential GDP between 2010 and 2013 (bottom half Table 2):

http://www.imf.org/external/pubs/ft/fm/2014/01/pdf/fm1401.pdf

The five core Euro Area nations that Simon Wren-Lewis considers (France, Netherlands, Belgium, Austria and Finland) increased their CAPB by a weighted average (according to 2010 nominal GDP) of 2.6% of potential GDP from 2010 to 2013. The GIIPS increased their CAPB by a weighted averaged of 5.0% of potential GDP from 2010 to 2013.

Between 2010 and 2013 nominal GDP (NGDP) increased by 12.3% in the US, by 6.2% in the core Euro Area nations and decreased by 1.8% in the GIIPS. Between 2010 and 2013 real GDP (NGDP) increased by 6.6% in the US, by 1.4% in the core Euro Area nations and decreased by 4.1% in the GIIPS.

It would have made absolutely no sense for any of the Euro Area nations to be doing fiscal stimulus when the ECB was nowhere near the zero lower bound and in fact raising the policy interest rates. Moreover the US economy has easily outperformed the economies of all of these countries in both nominal and real terms despite being at the zero lower bound in interest rates, and doing roughly the same amount of fiscal austerity as the GIIPS.

The one thing that the Great Recession, in tandem with the Great Depression, has made absolutely clear is that the liquidity trap is a myth promoted by those with a agenda no matter how much empirical evidence there is to the contrary.

So you think a recession can be caused by a central bank raising its interest rate from 1% to 1.5%! Obviously this did not help, but what I do not understand is why you want to minimise the role of fiscal policy. And what agenda do you think I have exactly?

Raising interest rates by *any amount* under those circumstances was an indication that the ECB thought core inflation should be even lower, and the output gap should be even larger.

What is incredulous is that anyone can look at this period of time and point to fiscal policy as the culprit when the US tightened fiscal policy twice as much as the core Euro Area nations you point to and suffered no recession in contrast to all of those nations, and the ECB tightens monetary policy in back to back policy rate moves and a recession ensues the following quarter.

So I gather you're asking us to totally ignore the smoking gun because...?!?

"Obviously this did not help, but what I do not understand is why you want to minimise the role of fiscal policy."

My motivation lies in the fact I would like to see economies everywhere recover from the Great Recession faster than they have done hitherto. The differing progress of the US and Euro Area is entirely explained by monetary policy, so why waste time drumming for a policy lever that has proven to be largely irrelevant during the recovery.

"And what agenda do you think I have exactly?"

It seems pretty clear to me based on your writings that you have a fair amount invested in proving that fiscal policy matters. Furthermore, why insert such patently false statements as the one I just quoted above into your blog posts?

So my motivation is the same as yours. That is why I argue for easier monetary and fiscal policy. Yet you are so sure that fiscal policy is unimportant, you are happy to let fiscal policy do what it likes. So where does your faith come from? Why do you discount the theoretical models or all the empirical evidence that says fiscal policy does matter?

So you claim. But if that is so why then assert that there is no controversy over the second Euro Area recession when thanks to your claim that the major factor was fiscal policy there evidently is, as I certainly don't think the major cause was fiscal, and I know many macroeconomists who share my belief. Do you think you are the only one who sincerely cares about the pace of the economic recovery and so this entitles you to run roughshod over evidence in favor of alternative explanations?

"That is why I argue for easier monetary and fiscal policy. Yet you are so sure that fiscal policy is unimportant, you are happy to let fiscal policy do what it likes."

And evidently you believe monetary policy is so unimportant that you are happy to totally ignore the most obvious cause of the second Euro Area recession, which was the two policy rate increases that immediately preceded it and blithly assert the major cause was fiscal policy when, if so, then the US economy should be in as poor a state as the Euro Area periphery.

"So where does your faith come from? Why do you discount the theoretical models or all the empirical evidence that says fiscal policy does matter?"

I discount it precisely because of the theoretical and empirical evidence. Certainly away from the zero lower bound very few macroeconomists (other than you) believe that fiscal multipliers are significantly greater than zero for any length of time. When was the Euro Area at the zero lower bound prior to 2013? Even now the ECB still has not lowered the MRO to zero as it claims it still can do.

1) I disagree with statement 1 because I do not think that the ZLB imposes much of a limitation on the efficacy of monetary policy. This is because most of the channels of the monetary transmission mechanism (MTM) do not even involve interest rates. Furthermore, this is strongly supported by the empirical evidence from current and past ZLB incidents.

2) I agree with statement 2 because cross sectional studies involving countries that are all members of the same currency area (such as the Euro Area), or with fixed exchange rates of some kind (such as the gold standard) , suggest that the fiscal multiplier is about 1 no matter what the policy rate is in the countries involved. If you control for monetary policy differences then, and only then, do fiscal policy differences become statistically significant.

mattski,Traditionally the Tobin's Q Channel, the Wealth Effects Channel, the Bank Lending Channel, the Unanticiapted Price Level Channel and the Household Liquidity Effects Channel are described as working through other means than interest rates. And although the Exchange Rate Channel is usually described as working via interest rates, it need not, as Bennett McCallum argued in 2001 and 2005 that it alone presents the means by which monetary policy can exert strong aggregate demand stabilization effects in ZLB conditions.

If the ZLB doesn't significantly limit monetary policy then why might fiscal contraction reduce output away from the ZLB but not at it?

It seems to me you respond to Simon's question about fiscal policy by changing the topic to monetary policy.

And *if* (don't want to assume) you believe that fiscal policy is useless because monetary policy will necessarily neutralize it, then *by what means* does monetary policy neutralize fiscal policy? Isn't it interest rates? (And why is this necessary?)

"If the ZLB doesn't significantly limit monetary policy then why might fiscal contraction reduce output away from the ZLB but not at it?"

Simon asked what *my* views are. Those are not necessarily the same as the great majority of macroeconomists. Personally I do not believe that the ZLB is a constraint on monetary policy. (And I have some good company in holding that view in the form of Romer, Eichengreen etc.) But there is a near consensus that, within reason, fiscal policy can always be offset by monetary policy *away from* the ZLB (and until very recently the Euro Area has been nowhere near the ZLB).

"It seems to me you respond to Simon's question about fiscal policy by changing the topic to monetary policy."

Simon's questions both refer to the ZLB, which in my opinion is only is relevant if he was referring to monetary policy. What did you think he was referring to?

"And *if* (don't want to assume) you believe that fiscal policy is useless because monetary policy will necessarily neutralize it, then *by what means* does monetary policy neutralize fiscal policy? Isn't it interest rates? (And why is this necessary?)"

Monetary policy offsets fiscal policy through any or all of the several channels of the MTM that monetary policy usually works, which by and large do *not* directly involve interest rates.

Both monetary policy and fiscal policy cause shifts in aggregate demand. It makes no more sense to be instituting fiscal stimulus while tightening monetary policy than it does to be flooring the accelerator while slaming on the brakes of your car (unless you enjoy the spectacle of burning rubber).

Mark - thanks for your reply of 7/June/17:20. We agree on (2) but disagree on (1): I think fiscal stimulus (or at least stopping continuing tightening) is a more predictable way of expanding activity than unconventional monetary policy at the ZLB. That is a perfectly reasonable disagreement.

However my reaction to this disagreement is not to denounce anyone who calls for more monetary easing. Instead I encourage both fiscal and monetary policy easing. If you have two instruments that can do a job, and its very unclear which if any will be used, it seems to me you want to encourage both.

It is the hostility from people like Scott Sumner and yourself when people like me just note that fiscal austerity will influence demand that I do not understand.

"I think fiscal stimulus (or at least stopping continuing tightening) is a more predictable way of expanding activity than unconventional monetary policy at the ZLB. That is a perfectly reasonable disagreement."

I think that this is true only because of the current manner inwhich almost all currency areas implement monetary policy. And consequently yes, this is a reasonable disagreement. It also isn't central to the issue raised in my initial comment.

"However my reaction to this disagreement is not to denounce anyone who calls for more monetary easing."

I am not denouncing your call for more fiscal stimulus just for the sake of denouncing fiscal stimulus. I am denouncing your implicit claim that there is a consensus that fiscal austerity is the major cause of the second Euro Area recession. This is obviously not true.

"Instead I encourage both fiscal and monetary policy easing. If you have two instruments that can do a job, and its very unclear which if any will be used, it seems to me you want to encourage both."

One possible way of conceptualizing this situation is as one involving two instruments (monetary and fiscal policy) and two targets ("full employment" and "debt sustainability"). J.W. Mason wrote a very readable post on that here:

My position is that, under this conceptualization, it has been customary to assign the full employment target (and by extension, under the assumption of a reasonably stable short run Phillips curve, the inflation rate target) to monetary policy, and the debt sustainability target to fiscal policy. There are good reasons for doing this, relating to the problem of which agent has more information and which agent moves first/last.

In order to justify switching the target of fiscal policy from debt sustainability to full employment I think it is very reasonable to first expect the exhaustion of the use of monetary policy in the attainment of full employment. Thus the usual justification for the use of fiscal stimulus is the existence of a "liquidity trap", which contemporarily is conceived as occuring when the central bank's policy rate approaches the ZLB.

At the beginning of 2011 the ECB's policy rate, the MRO, was 1.0%. This was raised to 1.25% in April and again to 1.50% in July. So not only was the ECB not at the ZLB, and hence was not in a "liquidity trap", it was tightening monetary policy. In other words the instrument which was assigned to do the job of attaining full employment was not only completely unconstrained, it was being used, and further it was being used to push the Euro Area away from the "job" which evidently we both think it should be doing.

Under such conditions what is the point of encouraging fiscal policy to switch from debt sustainability to full employment? It might be possible for an individual country on its own to attain full employment through fiscal policy, but given the behavior of the ECB it would be completely impossible for the Euro Area as a whole to attain full employment. And it goes without saying that the countries doing this would not be targeting debt sustainability optimally. Thus now instead of missing one target you are missing both.

The key to attaining the target assigned to monetary policy lies not in having fiscal policy abandoning its assigned target to attempt to do monetary policy's work for it (which is impossible if monetary policy is determined that it not be done), but in holding those responsible for the exercise of monetary policy accountable for having missed their target.

Policy is set by those who win the political fight, not necessarily by those who have the best policy ideas. What is best for the unemployed and most of the people in the economy is not necessarily best for the wealthy elites, the people Theodore Roosevelt described as "The Malefactors of Great Wealth". These elites are the patrons of our ruling class and our elites get the policies they want. They like cheap labor that results from high unemployment. They dislike tax and spend policies that tax their wealth and spend it on public goods and services that benefit everyone. They are unfairly accumulating all the gains of the recovery for themselves, increasing their wealth relative to others. The politicians have been bought by these wealthy elites and do their bidding whether or not the macro-economics community agrees with their policy.

Winning the debate with your fellow economists will not change the minds of a corrupt ruling class beholden to wealthy special interests. Wealthy special interests will buy shills or promote those who preach a message they approve. This gives cover to corrupt politicians who do the bidding of the wealthy. Corrupt politicians must be rooted out and replaced by competent people who will work for the good of all people, not just for the wealthy few. Meritorious arguments do not matter to corrupt politicians with excuses.

The important point is not that our rulers ignore meritorious policy. The important point is our rulers are corrupt and work for the interests of the wealthy few to the detriment of everyone else.

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